Does your business earn income from making and exporting goods, such as agricultural products, apparel or software? If so, in connection with such exports, does your company use a “domestic international sales corporation,”[1] or DISC? If not, you are missing out on a relatively easy way to substantially reduce your federal income taxes attributable to your foreign sales. There may be state income tax benefits from using a DISC as well.
Do you qualify for a DISC?
Do you manufacture goods in the United States and export them overseas? If yes, you probably qualify for a DISC.
“Manufacturing” is broadly defined for this purpose. In general, any assembly in the United States will qualify as well as agricultural products. Certain foreign construction services also qualify.
What is a DISC?
A DISC is a domestic corporation that makes a tax election to be treated as a DISC. It is typically owned by the exporting company or by the owners of the exporting company. It must also meet a few technical requirements that typically are not difficult to meet if you work with legal and tax professionals with expertise in the field.
In general, a DISC generally is a mere bookkeeping entity that operates in accordance with the terms of a written agreement with a related exporting company. It is not required to perform substantial business functions. Thus, DISCs do not require office space, employees or tangible assets.
Under the written agreement described above, the exporting company either pays a commission on its foreign sales to the DISC (a so-called “commission DISC”) or makes a portion of its foreign sales through the DISC (a so-called “sales DISC”). It is typically easier to form a commission DISC than a sales DISC, but depending on your facts you may obtain greater tax benefits by using a sales DISC.
Tax Savings
In general, your federal income tax burden will fall by at least 50% on half of your taxable income from your foreign sales. You may save state income taxes as well.
At a minimum, an exporting company (which can be a “C” corporation, “S” corporation, partnership or LLC) can run at least 50% of its taxable income attributable to foreign sales through a DISC. And, DISCs do not pay any entity-level taxes. Rather, the DISC’s earnings are taxable to its owners when they are paid out as dividends to the owners. These dividends generally are taxable at capital gains rates.
For example, assume that an S corporation earns $200 in taxable income attributable to its foreign sales. The S corporation can run at least $100 of such taxable income through a DISC. As such, the owners of the S corporation will save $39.60 ($100 x 39.6%—the highest individual ordinary income tax rate) in federal income taxes. While the DISC doesn’t pay federal income tax, when it pays out a dividend of $100 to the owners, they must pay $20 in federal income tax on such income ($100 x 20%—the highest individual long-term capital gain rate). Thus, the DISC generally reduces tax from about $40 to $20 on half of the S corporation’s taxable income attributable to its foreign sales.
In addition, to a limited extent, you may use a DISC to defer a portion of the taxable income running through a DISC; that is, you need not pay tax currently as such taxable income.
There may be gift and estate planning opportunities to using a DISC as well.
What should you do next?
If you manufacture in the United States (which is broadly defined) and sell overseas, you should consider a DISC. While a DISC is not difficult to form, they require certain documentation and must be managed properly. DISCs are often audited by the IRS.
Also, there are several “traps for the unwary,” including numerous compliance tests, limitations and occassionally complex state income tax considerations (e.g., California income and franchise taxes). You should work with legal and tax professionals who have expertise with DISCs.
[1] Technically, an “interest charge domestic international sales corporation.”
